Sunday, July 30, 2017

Given
the company’s weak financial condition and the behavior of management, those
with a financial interest in the firm—creditors and equity investors— need all
the help they can get in monitoring DG’s performance.

As always AA has your back.

In addition to
keeping an eye on macro financial performance, here are a few relatively quick
things that sukuk holders and equity investors can do to make sure they don’t
miss problems organized around three topics:

Current performance

Receivables
collection

Financial liabilities

These
aren’t the only indicators.

They
certainly are not replacements for looking at the financials carefully
particularly aggregate cashflow, but can be helpful in identifying performance
problems.At times information in the
consolidated income statement or statement of condition can be used to trigger
a deeper look.For example, declines in
overall net revenue, a sudden large write-off of exploration costs, etc. should
send you looking for more information.You’d expect to find explanations in the various management reviews in
annual and interim financial reports. These tools will hopefully help you look
deeper.If management omits to highlight
a problem, these tools may help you discover incipient problems as well.

Current Performance

DG operates in three
separate locations.Looking at aggregate
performance obscures what’s happening on the individual level. That could be quite important if the level is a critical "bit" in the overall business.

DG does provide some information on
individual operations in its “segment reporting” note (typically note 4). Here you'll find total assets and liabilities. Not enough to go on.
Starting in 2013 DG began providing more information on Pearl's balance sheet in the note Interest in Joint Operations (note 15 in 2016 and 13 in 2014) than in note 4. One can create a rudimentary balance sheet from this information back to 2012. That still leaves a significant information gap on the balance sheets of Egypt and the UAE.

But there is another more important problem with DG's segment disclosure. The Company does not disclose net income and net comprehensive income for the UAE,
Egypt, and Iraq.It only discloses net
revenues and gross profit (net revenue – depreciation and operating expenses) with
some additional limited disclosure about elements of the income statement. Sadly this falls short of what would be ideally useful to users of its financial statements.

With this limited additional information, one can
try to construct a rudimentary income statement. But more than some assembly is
required. Unlike IKEA not all the parts
are in the box, so it’s generally hard to determine whether these entities are
profitable before allocation of expenses at the holding company (DG) level or
the nature of at least two of the three main operating entities' balance sheets.

In
some cases where there is an extraordinary expense, e.g., a substantial
write-off of exploration expenses, it’s a bit easier.For example, in 2009 it’s pretty clear Egypt
had a net loss.As did Zora in
2016.One doesn’t even need a calculator
to see this.

What’s a quick but not
complete fix to this lack of information?

Tracking the top line for
an indication of ability to generate earnings and cashflow and looking at the disclosed expenses is the easiest. It's also not a bad starting point. But this is an imperfect "fix".Revenue declines or increases can reflect changes in prices or volumes.One would
expect prices to be largely out of DG’s control.Volume declines could reflect operating or
reserve problems. One can also scan the disclosed expenses for surprises. These should be visible in the consolidated income statement but looking at the segment information note (note 4) will identify which of the three businesses took the "hit". Here’s a starting
point for the investors out there who hold DG paper.

DG
Top Line Revenues Millions of USD

UAE

Egypt

KRG

Total

2016

23

154

78

255

2015

4

125

142

271

2014

4

225

247

476

2013

5

225

230

460

2012

5

237

258

500

2011

5

290

226

521

2010

4

264

82

350

2009

4

192

42

238

Source: Note 4 DG Annual Reports

Trade
Receivables (“TR”)

As discussed in earlier posts, collecting TR is key to repayment of
the Sukuk and to eventual cash returns to shareholders. (AA is indulging in extremely
optimistic fantasies today). The TR are “whisker-growing” stale.Cash conversion is glacially slow.On a present value basis, the value of TR is
being eroded when one considers the appropriate risk-adjusted discount rate.

Those with a financial interest in DG’s
financial performance should be watching trends in collection or further
accumulation of the TR.Note to DG’s
auditor: Transparent disclosure of just how past due the TR would be helpful.

Provisions for Surplus Over Entitlements

But
there’s something new to watch.That is
the above mentioned provision which is money that DG owes the KRG.

Why is this
important?

AA suggests you read Note 28
in full, but here is a sentence that caught AA’s eye and summarizes the issue:

“Furthermore, Pearl has a right under the terms of the Authorisation to offset this Surplus, when payable, against any other outstanding payments due from the KRG.”

Given its current cashflow generation
problems, it’s likely that if the TR are settled, the amounts owed to the KRG
will be offset against the TR. The KRG may have a similar right to offset. But we don't have confirmation of that. AA would expect that those who depend on
collection of the TR for their repayment or dividends would want to track whether
this offset is growing and just how fast.Is this liability threatening to seriously diminish their source of
repayment?

Side comment:Though none is really needed in AA’s view, perhaps
this is another compelling argument that sukuk holders should reject a five-year bullet
structure and insist on amortization of the sukuk in the rescheduling
negotiations.As you will recall and if
you don’t, AA will repeat his earlier advice.Principal
payment should be in the form of both scheduled repayments and a cash sweep
structure to hoover up prepayments if there is excess cash.

Bonus Indicators

In addition to the operational indicators
mentioned above, some "bonus" tips.

If you missed the reference in DG’s Annual Report 2016 CEO Review, there seems to be a problem of some sort at Zora.

“In the UAE, despite full year average production of 2,744 boepd, total production from the Zora Gas Field has declined throughout the year from production start-up in February.”

This may be a technically solvable problem or it may not.

Those with a financial
interest are likely to have an interest in knowing, though Zora is a rather
small fish in DG’s operations.It clearly
is not showing a profit based on DG’s Annual Reports Note 4.

This information
may also temper optimism about Zora as additional collateral until the cause of
the decline is known.

For Pearl there
are other sources of information (more on that point in a post to come) in the financial reports of three of DG’s partners in the joint operations.Here are some examples from MOL Hungary’s
2016 annual report.

MOL took provisions equal to its share of 2016
net income in Pearl Petroleum (note 6).

“Given the current economic situation impacting the Group’s associate in the Kurdistan Region of Iraq a provision has been made in 2016 against the Group’s share of profit.”

MOL
also announced that it has changed its revenue recognition for sales in the KRG
from an accrual to a cash basis. That’s generally not a sign of robust credit standing of the buyers.(AA’s first understatement of the post). And may be related to the 2016 provisioning against MOL's profit in Pearl.

Note 3:“Having assessed the probability of receiving economic benefits from sales activities in Group’s operations in Kurdistan the management decided to recognise revenue on a cash basis on sales in Kurdistan Region of Iraq.”

MOL has
also taken some additional steps in the KRG which appear to reflect a serious
concern about economic conditions.You
can easily find them by searching MOL’s
2016 annual report using the search term “Iraq”.Pearl isn’t MOL’s only KRG asset so some of
these steps relate to other companies. But the message seems pretty clear.MOL is concerned about KRG ability to repay.

AA Rant

If you read this blog on a semi-regular basis, you’re familiar—perhaps more than
you’d like—with AA’s frequent complaints about "shortcomings" financial reporting.

This rant is about the quality of DG’s segmental
information. I’ve noted the deficiencies above. In short DG isn't providing enough information to understand it's underlying business.

Why isn’t DG providing more detailed
information?

Others do. The nearest I
can find to an “explanation” is in DG’s 2016 annual report notes 2 and 4.The below quotes basically repeat what
they’ve said in previous years.

“Note 2: Operating segments are reported in a manner consistent with the internal reporting provided to the Chief Operating decision-maker.The Chief Operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as the Chief Executive Officer who makes strategic decisions.”

“Note 4:Management has determined the operating segments based on the reports reviewed by the Chief Executive Officer (CEO) that are used to make strategic decisions. The CEO considers the business from a geographic perspective which is divided into three geographical units.The Group’s financing and investments are managed on a Group basis and not allocated to segment.”

This might be
charitably described as manifest garbage.

DG’s segments are independent
companies that prepare their own financials.

What this means is that DG has
this information. Preparation of the segmental information would be a simple
matter of reproducing summaries of the income statement and balance sheet.

AA wonders if the CEO really does not look at these reports or condensed versions of
them to make decisions. How can he run the business and make investment
decisions if he isn't tracking the profitability of major lines of
business based on an allocation--imperfect as it is likely to be--of all expenses?How does one track risks?

If indeed the CEO is not using a methodology similar to this, then perhaps DG needs a new CEO.

AA also wonders
DG’s auditor’s apparent acceptance of this explanation. Some uncharitable souls might
say questions about auditor credulity have already been conclusively answered: the auditor has accepted DG’s decision to carry the Trade Receivables as
“current assets”.

When important information is missing from financials or other statements by a firm's management, one should wonder why. Is it that they don't have the information (which is a troubling question in its own right)? Or that they don't want to release the information (an even more troubling question)? That leads to AA's golden rule of providing capital. If the firm doesn't trust you with information, why should you trust them with your money?

2 comments:

With Dana Gas now repealing their offer to re-issue the sukuk on more favorable terms, and instead pursuing a court determined outcome, one presumes no sane investors will lend to the firm or subscribe to any new equity it issues.

We struggle to see how DG can remain a going concern at this rate, unless these KRG receivables are literally on the cusp of being paid.

I puzzled as well. DG seems to have gone from "clever boots" to "clever socks" with its strategy.

Unless for example, ....

the legal structure of the deal is unsound. That is, rights to the trust assets are not enforceable.

legal procedures in the UAE regarding corporate insolvency/bankruptcy are such that creditors' rights are largely imaginary. Or that procedures can be made to proceed at a glacial pace. Two unrelated points: (1) NBUQ and Global Kuwait were in an epic legal battle in the UAE. (2) The DIFC exists because the Dubai Govt believes that the UAE onshore legal system is unsatisfactory.

As to payment by the KRG, there were some press reports in 2016 that the KRG was pushing Washington for funds to fight ISIS claiming their finances were tight. I recall seeing figures being thrown around in the press that the KRG was $18 billion in debt then. Plus the usual problems with corruption.

The "problem" then was ascribed to Baghdad tightening the financial screws on the KRG by withholding funds. A key issue related to KRG revenues is the volume of their direct sales to/through Turkey versus those through SOMO. If they sell through SOMO, then Baghdad decides how much they get paid and when they get paid. Direct sales were (are?) at lower than market prices and there is a limited customer base. Turkey no doubt likes the greater energy independence that KRG sales represent but perhaps not enough to see the KRG become independent. In any case for DG to get paid in full, the KRG has to cut a check for roughly USD 2 billion. That's no small amount.

Have you heard anything more recent about KRG? Any thoughts about the accuracy of press reports I mentioned above.